Upside down auto loans

Seriously Upside-Down

by Gary Foreman

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I have a Yukon XL with over 90,000 miles on it. I still owe $26,000 on it and it is worth about $13,000. I am dying with the car payments at $840 a month. We had a dual income when we bought it, but circumstances changed. Is there any way at all to trade to a minivan and make payments in the neighborhood of $500 a month? I think we still have three more years of payments.Violet

Violet has a lot of company. Lots of people are "upside-down" in their auto loans. That means that they owe more than the car is worth. In fact, about 30% of all new cars financed include an upside-down trade-in. The average amount added to the new car loan was nearly $3,800.

The problem can be painful. When you owe more than your vehicle is worth, the dealer and lender holds most of the cards. They know that you'd have a hard time selling your car "by owner" since that would require coming up with a lot of money.

Plus, the lender is going to want a higher interest rate on the new loan. That's because the loan is for more than the car is worth. If they did have to repossess, they would be far short of the outstanding loan balance.

Finally, the extra debt means that you'll be upside-down for a longer period of time in your new vehicle.

Auto loans have changed to mask the problem. Today the average car loan is over five years. And, it is getting longer.

So let's look at Violet's situation. She's big-time upside-down in her Yukon. Plus, she's struggling with the hefty monthly payments. And, she'd like to get into something less expensive like a minivan.

Could she trade for a minivan and roll the unpaid $13,000 onto her new loan? Not very likely. At least not with a reasonable payment.

Suppose that she found a $20,000 minivan. She'd be financing $33,000. The van will lose approximately 35% in the first two years (source: Bankrate.com). So two years from now, the finance company is going to have a $13,000 van as collateral for a $30,000 loan! They won't do that for 10% interest. The risk is simply too great.

Violet has gone beyond the point where she can reasonably roll the balance onto a new loan. And, even if she could find financing, she'd be upside-down in her minivan until it rusted away!

Can Violet reduce her payment? To do that, she'd need to lower her interest rate or increase the length of the loan or both.

In Violet's case, she's probably not going to get a lower interest rate. In part, it's because only half of the loan is collateralized (i.e. the vehicle is only worth half the amount that's owed on it).

But she might be able to extend the life of the loan. If she were to go to six years, the payment would drop to $481 per month. The best way to do that is to approach her current lender. They might let her do that for two reasons. They'll collect twice as much in interest ($8,680 vs. $4,202) and they don't want to repossess Violet's SUV and take the loss.

A second possible solution would be to use a different source to raise money to pay off the vehicle loan. Two possibilities are either a homeowner's line of credit or a 401k loan.

In both cases, she'll get a reasonable interest rate. Possibly, it will be lower than her current 10%. She'll also be able to extend the loan beyond the current three year period, which will also lower her payments. Before borrowing against her home or her 401k, Violet needs to find out about those types of loans so she understands the risks involved.

What can we all learn from Violet's experience? A number of valuable lessons. Longer auto loans can be dangerous because circumstances change. New car loans can last up to 72 months. No one can reasonably predict job, health and family circumstances six years into the future.

Car payments that are too high for your budget can be very expensive. If you struggle to make the car payments, you'll probably shift other expenses to your credit card. And, that can be very expensive debt. Up to 30%!

Rolling over debt from your current vehicle onto your next car is dangerous, especially if it's more than a about 10% of your new car price.

Hopefully, Violet will be able to ride out this rough stretch of road and will stay right-side-up in future vehicles.

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and he's a regular contributor to CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

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